Don’t Be Left Holding The Short End Of The Stick
It’s a new year, which means it’s also time to update your buy-sell agreement!
Generally speaking, we recommend that all business owners review their buy-sell agreement annually from a legal and valuation perspective. If you don’t, there might be some unfortunate news in your future.
We recently prepared the valuation of a company that was valued at $3 million, equally owned by two shareholders. The existing “buy-sell” agreement was executed in the ’90s. According to the existing agreement, the stated value of the company was $50,000 for any triggering event. That may have looked a lot better when “Friends” was still on the air, but today, the results would be devastating.
For example, under the circumstances outlined above, consider what would happen if one of the two shareholders were to pass away? Do you think it would it be fair to the deceased owner’s family to obtain $25,000 for his interest in the company upon death, which is now valued at $3 million? We don’t think so either.
Buy-sell agreements are contracts among the shareholders that control what will happen to the stock of the company under certain pre-determined purposes. The purpose of the buy-sell agreement is to control who can be part of ownership in the business, and to provide financial resources to the departing shareholder.
From the valuation perspective, the main issue is, “What will the value be when the trigger event happens and is this value fair and reasonable to all parties involved?” These parties include: the departing shareholder or their family, the business entity, the other shareholders and, in the case of death, the IRS.
It’s very difficult to use a simple formula to calculate an accurate valuation for a complex business. The value of a business is based on future cash flow and risk associated with the expected cash flow. Additionally, the strength or weakness of the balance sheet needs to be factored into the ultimate value.
Most formulas included in buy-sell agreement tend to look at recent history, failing to factor in the balance sheet. For example, say a business had a profit of $1 million in the prior year. Is the value a simple multiple of the prior year earnings? Would that value still be correct if the business lost a major customer? Should a business that has $2 million of cash and no debt be valued the same as a business that has $2 million of debt and no cash? Needless to say, this is a pretty complicated prediction to make.
There are so many factors that go into a business valuation, and since each business is unique, the valuation needs to be unique as well. No one simple formula can capture this.
Contact our team of business valuation experts today for help updating your company’s buy-sell agreement.
By Duncan Copeland (Dublin office)